Geography, Trade, and Currency Union

Abstract

Abstract This chapter reports on four basic results of tests of the standard gravity equation. First, geography can reflect comparative advantage as well as transportation cost. Second, the effect of distance on bilateral trade is mostly a substitution effect between closer and more distant trade partners rather than a scale effect on total foreign trade. Third, special political relationships, such as free trade agreements and currency union, do not produce any trade diversion in the aggregate, but increase trade with outsiders as well as among the parties to the relationship. Fourth, Rose’s surprisingly high estimate of the impact of currency union on trade stems partly from selection bias, but even following a correction for that bias, the estimate remains high.

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